The term ‘portfolio’ is usually applied to combinations of securities, but the principles underlying security portfolio formation can be applied to combinations of any type of assets, including investment projects. Most firms diffuse their efforts across a range of products, market segments and customers in order to spread more thinly the risks of declining trade and profitability. If a firm can reduce its reliance on particular products or markets, then it can withstand more comfortably the impact of a major reverse in any single market. Diversification can generate some major strategic advantage, for example, the wider spread of activities, the greater the potential access to high performing market sectors. The modern portfolio theory was developed by Harry Markowitz, presenting it in 1952 in an article entitled ‘Portfolio Selection’. Markowitz was the first to show the important benefits from diversification that arise from combining individual securities into portfolios and to demonstrate that the portfolio decision problem of an investor is equivalent to the maximisation of his or her expected utility. Modern Portfolio Theory explores how risk averse investors construct portfolio in order to optimise market risks against the expected return. The theory suggested that we could reduce the standard deviation of returns on asset portfolio by choosing assets, which do not move together. Allocating funds to a single security can be an extremely risky investment.
The Dissertation on Risk Theories
Risk Theories 1 Information Security and Risk Management Theories William Butler Risk Theories 2 Information Security and Risk Management Theory Leaders use risk management framework to describe an organizations risk management process (Jones, 2007). There are risk management models from which organizational leaders can choose to base their risk management framework upon. All of the risk ...
The primary reason for investing in portfolios is diversification, that is, the allocation of funds to a variety of securities in order to reduce risk. As the number of securities held in the portfolio increases, the overall variability of the portfolio’s return, measured by its standard deviation, diminishes very sharply for small portfolios, but falls more gradually for larger combinations. This decline in risk is achieved because the exposure to the risk of volatile securities can be offset by the inclusion of low-risk securities or even high-risk ones, so long as their returns are not closely correlated. The key point here is that not all the risk of individual securities is relevant for assessing the risk of a portfolio of risky shares. The total risk of a portfolio is composed of two components: 1. Specific risk. The variability of a security’s rate of return due to factors unique to the individual firm.
2. Systematic risk. The variability of a security’s rate of return due to dependence on factors which influence the return on all securities. Specific risk refers to the expected impact on sales and earnings of largely random events like industrial relations problems, equipment failure, R&D achievements. In a portfolio of shares , such factors tend to cancel out as the number of component securities increases. Systematic risk refers to the impact of movements in the macro-economy, such as fiscal changes, swings in exchange rates and interest rate movements, all of which cause reactions in security markets, captured in the movement of an index reflecting securities prices in general.
No firm is entirely isolated from these factors, and even portfolio diversification cannot provide total protection against this form of risk. For this reason, it is often called market risk. Reduction in the total risk of a portfolio is achieved by gradual elimination of the risks unique to individual companies, leaving an irreducible, undiversifiable, risk floor. Substantial reduction in specific risk can be achieved with quite small portfolios, and the main scope for risk reduction is achieved with a portfolio of around thirty securities. To eliminate unique risk totally would involve holding a vast portfolio comprising all the securities traded in the market. This is called market portfolio and has a pivotal role in the CAPM, but for the individual investor it is neither practicable nor cost-effective, in view of the likely scale of the dealing fees required to construct and manage it. Since relatively small portfolios can capture the lion’s share of diversification benefits, it is only a minor simplification to use a well-diversified portfolio as a proxy for the overall market such as one of the well-known market indices 1. It is clear that risk-verse investors should diversify 2.
The Research paper on Risk and Return Analysis
... The possibility of variation of the actual return from the expected return is termed risk. Corporate securities and government securities constitute important investment avenues for investors. ... cash through the stock exchanges. An individual or an institution can either hold a portfolio of securities as a permanent investment, or he ...
Investors should not expect rewards for bearing specific risk 3. Securities have varying degree of systematic risk The rate of return of a portfolio can be described by a probabilty distribution. The assumption is that such a probability distribution can only be characterized by its expected return and the variances of rates of return. The rate of return on a two-security portfolio is a weighted average of the rates of return on the two individual securities in the portfolio, where the weight associated to a security is the proportion of portfolio funds invested in the security. The expected return on a portfolio E(R) comprising 2 assets a and b, whose individual expected returns are E(Ra) and E(Rb) and a and 1- a are respective weightings. The riskiness of the portfolio expresses the extent to which the actual return may deviate from the expected return.
This may be expressed in terms of the variance of the return s2 or in terms of its standard deviation s. Portfolio analysis deals with the calculation of the efficient frontier. The outputs will be an efficient frontier; a set of portfolios with expected return greater than any other with the same or lesser risk, and lesser risk than any other with the same or greater return. Portfolios lying along the efficient frontier dominate all other risk/return combinations lying to the right or below the efficient frontier. They are clearly better than any in the interior of the shaded area. The individual securities can be combined into portfolios. All the possible combinations represent the set of available investment opportunities.
Among these opportunities we prefer the portfolios with the higher expected returns and lower standard deviations. Once the efficient frontier is identified, the investor’s risk/return preferences are taken into consideration The final choice of an individual investor is dependent upon the following two factors: (a) his/her preferences regarding a particular risk/return combination; and (b) relevant investment opportunities on the efficient frontier. A combination of these two factors gives the investor’s optimal portfolio, i.e., the efficient portfolio that maximazes his/her expected utility with reference to the risk/return trade off. Investors will prefer one of the portfolios on the efficient frontier and their selection depends upon personal preferences for a low portfolio expected return versus a larger and more risky portfolio expected return. However we cannot specify an optimal portfolio, except for an outright risk-minimizer, who would select portfolio D or the maximizer of expected return who would settle at poit A. A risk averse investor might select any portfolio along AD, depending on his degree of risk aversion, i.e, wha ….
The Term Paper on Risk And Net Present Value
... balance risk and reward. These comprise what Markowitz called an efficient frontier of portfolios. An investor should select a portfolio that lies on the efficient frontier. James ... calculate the expected return and volatility of any portfolio constructed with those securities. We may treat volatility and expected return as proxy’s for risk and reward. ...
